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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

Personal Finance, Part 5 — Inflation and Deflation

This is another in the irregular series on personal finance. This article though, has implications beyond individuals. I’m going to describe this in US-centric terms for simplicity sake. For the 20-25% of my readers that are not US-based, these same principles will apply to your own country and currency as well.

Let’s start with inflation. Inflation is predominantly a monetary phenomenon. Whenever the Fed puts more currency into circulation on net, there is monetary inflation. Some of the value of existing dollars gets eroded, even if the prices of assets or goods don’t change. In a growing economy with a stable money supply, there would be no monetary inflation, but there would likely be goods price deflation. Same number of dollars chasing more goods.

Let’s move on to price inflation. There are two types of price inflation, one for assets, and the other for goods (and services, but both are current consumption, so I lump them together). When monetary inflation takes place, each dollar can buy less goods or assets than in the absence of the inflation. Prices would not rise, if productivity has risen as much or more than the amount of monetary inflation.

Now, the incremental dollars from monetary inflation can go to one of two places: goods or assets. Assets can be thought of as something that produces a bundle of goods in the future. Asset inflation is an increase in the prices of assets (or a subgroup of assets) without equivalent improvement in the ability to create more goods in the future. How newly printed incremental dollars get directed can make a huge difference in where inflation shows up. Let me run through a few examples:

In the 1970s in the US, the rate of household formation was relatively rapid, and there was a lot of demand for consumer products, but not savings. Money supply growth was rapid. The stock and bond markets languished, and goods prices roared ahead. Commodities and housing also rose rapidly.

In the mid-1980s the G7 induced Japan to inflate its money supply. With an older demographic, most of the excess money went into savings that were invested in stocks that roared higher, creating a bubble, but not creating any great amount of incremental new goods (productivity) for the future.

In 1998-1999, the Fed goosed the money supply to compensate for LTCM and the related crises, and Y2K. The excess money made its way to tech and internet stocks, creating a bubble. On net, more money was invested than was created in terms of future goods and services. Thus, after the inflation, there came a deflation, as the assets could not produce anything near what the speculators bid them up to.

In 2001-2003 the Fed cut rates aggressively in a weakening economy. The incremental dollars predominantly went to housing, producing a bubble. More houses were built than were needed in an attempt to respond to the demand from speculators. Now we are on the deflation side of the cycle, where prices adjust down, until enough people can afford the homes using normal financing.

I can give you more examples. The main point is that inflation does not have to occur in goods in order to be damaging to the economy. It can occur in assets when people and institutions become maniacal, and push the price of an asset class well beyond where its future stream of cash flow would warrant.

Now, it’s possible to have goods deflation and asset inflation at the same time; it is possible to save too much as a culture. The boom/bust cycles in the late 1800s had some instances of that. It’s also possible to have goods inflation and asset deflation at the same time; its definitely possible to not save enough as a culture, or to have resources diverted by the government to fight a war.

The problem is this, then. It’s difficult to make hard-and-fast statements about the effect of an increasing money supply. It will likely create inflation, but the question is where? Many emerging economies have rapidly growing money supplies, and they are building up their productive capacity. The question is, will there be a market for that capacity? At what price level? Many of them have booming stockmarkets. Do the prices fairly reflect the future flow of goods and services? Emerging markets presently trade at a P/E premium to the developed markets. If capitalism sticks, the premium deriving from faster growth may be warranted. But maybe not everywhere, China for example.

The challenge for the individual investor, and any institutional asset allocator is to look at the world and estimate where the assets generating future inflation-adjusted cash flows (or goods and services) are trading relatively cheaply. That’s a tall order. Jeremy Grantham of GMO has done well with that analysis in the past, and I’m not aware that he finds anything that cheap today.

We live in a world of relatively low interest rates; part of that comes from the Baby Boomers aging and pension plans investing for their retirement. P/E multiples aren’t that high, but profit margins are also quite high. We also face central banks that are loosening monetary policy to reduce bad debt problems. That incremental money will aid institutions not badly impaired, and might eventually inflate the value of houses, if they get aggressive enough. (Haven’t seen that yet.) In any case, the question is how will the incremental dollars (and other currencies) get spent? In the US, we have another demographic wave of household formations coming, so maybe goods inflation will tick up.

We’ll see. More on this tomorrow; I’ll get more practical and less theoretical.

About David Merkel

David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does — on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor’s and master’s degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth. View all posts by David Merkel →